Economic History of India : An Short Note

An Short Introduction:

Indus valley civilization, which flourished between 2800 BC and 1800 BC, had an advanced and flourishing economic system. The Indus valley people practiced agriculture, domesticated animals, made tools and weapons from copper, bronze and tin and even traded with some Middle East countries.

Agriculture was the main economic activity of the people in the Vedic age but with the second urbanization a number of urban centers grew in North India. This gave a major fillip to trade and commerce. The ancient Indians had trade contacts with far off lands like the Middle East, the Roman Empire and the South East Asia. Many Indian trading colonies were settled in other countries.

Most of the Indian population resided in villages and the economy of the villages was self-sustaining. Agriculture was the predominant occupation of the populace and satisfied a village’s food necessities. It also provided raw materials for industries like textile, food processing and crafts. Besides farmers, other classes of people were barbers, carpenters, doctors, goldsmiths, weavers, etc. In towns and urban centers trade took place through coins but in villages barter was the main system of economic activities.

The system of castes and sub-castes ensured division of labor and functioned much like guilds, providing training to apprentices. The caste system restricted people from changing ones occupation and aspiring for an upper caste’s lifestyle. Traditionally, there was joint family system and the members of a family pooled their resources to invest in business ventures.

Products like the muslin of Dhaka, calicos of Bengal, shawls of Kashmir, textiles and handicrafts, agricultural products like pepper, cinnamon, opium and indigo were exported to Europe, Middle East and South East Asia in return for gold and silver.

With the coming of Europeans in the 16th century trade and commerce was completely transformed. The Europeans concentrated mainly on spices, handicrafts, cotton clothes, indigo etc. Of all the European powers the British proved most strong and drove their competitors out of India. Slowly and gradually the British acquired political supremacy and hold over India and subverted the Indian economy according to their own needs. With the establishment of British rule in India the drain of wealth from India began. There was poor industrial infrastructure when the British left India.

After independence, India opted for planned economic development. The key concern was to develop thrust and heavy industries. With this there began rapid industrialization. Here, it is important to note that our economic policies were socially oriented and controlled by the state. India began to follow a mixed economy pattern. But in the late eighties and in the beginning of the 1990s, the Indian policy makers realized that state controlled economy was not able to produce desired results in almost 45 years. It was decided to pursue economic policy based on liberalization, privatization and globalization. In this era of liberalization, privatization and globalization, India has witnessed rapid growth in some sectors of economy, even though better results were expected when India began to follow the new economic policy.

India: How a rich nation became poor and will be rich again

Does ‘culture’ in some way help to explain the fact that the same Indian economy that was stagnating for the first fifty years of the 20th century began to grow at a respectable clip after 1980 and was amongst the fastest growing in the world by the end of the century?

Consider the following hundred year trend: between 1900 and 1950, the Indian economy grew on the average 0.8 percent a year; but the population also grew at about the same rate; thus, net growth in income per capita was nil and we rightly called our colonial economy stagnant. After Independence, economic growth picked up to 3.5 percent between 1950 and 1980, but so did population growth (to 2.2 percent); hence the net affect on income was 1.3 percent per capita, and this is what we mournfully referred to as “the Hindu rate of growth.” Things began to change with modest liberalization in the eighties when annual economic growth rose to 5.6 percent. This happy trend continued in the reform decade of the nineties when growth averaged 6.2 percent a year, while population slowed to 1.8 percent; thus, per capita income rose by a decent 4.4 percent a year.

TABLE: INDIAN GROWTH 1900-2000

Colonial Post-Independence Reform Period

1900-1950

1950-1980

1981-1990

1991-2000

GDP growth

0.8

3.5

5.6

6.2

Per capita growth

0

1.3

3.5

4.4

Sources: 1900-1990: Angus Maddison (1995), Monitoring the World Economy, 1820-1992 (Paris:OECD); 1990-2000: World Bank/IMF. Although 1991 is the celebrated turning point of India’s economic reforms, modest and significant reforms began in the 1980s as I explain below.

As a benchmark, recall that the West’s industrial revolution took place at a 3 percent GDP growth and 1.1 percent per capita income growth after 1820. To appreciate the magnitude of the Indian change after 1980, let me illustrate: If India’s per capita GDP had continued growing at the pre-1980 level, then its income would have reached present American capita income levels only by 2250; but if it continues to grow at the post-1980 rate then it will reach those levels by 2066: a gain of 184 years!

How does one begin to explain India’s economic performance over the past hundred years? The Indian nationalist blames the first fifty years’ stagnation on British colonialism. But a trade economist will counter this by showing that the world economy was also stagnant in the first half of the 20th century (especially after World War I) when world per capita GDP grew annually at just under one percent.2 The main culprits, he would say, were conflict and autarky. Disgraceful protectionism by most governments between the Wars slowed both the world and the Indian economy.

Although the Indian economy picked up after 1950, the neoclassical economist would argue that it performed below the world economy, which experienced a “golden age” driven by trade expansion until 1971. Like the rest of the Third World India did not benefit from global trade expansion because it had closed its economy and pursued ‘import substitution’. Moreover, Nehru’s socialism had shackled the economy with fierce controls on the private sector, pejoratively called ‘Licence Raj’; hence its annual GDP growth was 1.5 percentage points below even the Third World average between 1950 and 1980.3

This changed dramatically with modest liberal reforms in the 1980s and more sweeping ones in the 1990s as the Indian economy integrated with the world. In those twenty years it not only outperformed the world economy significantly but it was amongst the fastest in the world.4 Thus, gradual technological diffusion, rising capital accumulation and productivity, and gradual education expansion help economists to explain a good deal of the story. There is also the value of time and accumulated learning through time. “Collective learning” is Hayek’s term, and he applied it to the cumulative experience that generations build up which is embodied in the language, the technology, and the way of doing things.5

But economic explanations are not enough. That India adopted democracy in 1950 before capitalism (in 1991) is also significant because democracy’s redistributive pressures, such as free power to farmers and other subsidies, have dampened growth and also explain why India’s reform process has been so painfully slow. Economists also find it puzzling why the liberal institutions of the British Raj did not engender faster growth during the colonial years. The rule of law, the relative peace of Pax Brittanica, a non-dirigiste administration, the railways and canals—all these were market friendly moves, after all.

I believe that national confidence also plays an important role. The more damaging impact of colonialism may well have been to Indian minds—it created an inferiority complex from which they have only recently recovered. Douglass North has rightly emphasized the importance of beliefs.6 Businessmen understand the value of confidence in entrepreneurial success and in creating a climate for investment; Historians too emphasize the power of self-belief in national success–Roman history and Britain’s rise in the 19th century are examples of this. After Independence, India’s confidence certainly rose, especially as democracy took root, but flawed economic institutions of Nehruvian socialism damaged that confidence. Once these socialist institutions began to be replaced by capitalist ones in the Reform period, confidence returned and young Indian minds finally became decolonized. I traveled extensively across India in the 1990’s when I discovered this changed mood, and I think it also explains the current economic success.7

I shall now amplify my arguments by taking the reader on a galloping tour of Indian economic history. From this story I shall draw lessons about the role of institutions and culture in development. En passant, I shall touch upon the great questions of Indian history: did the British impoverish India? Why didn’t the railways engender an industrial revolution? Did Nehru’s socialism dampen India’s progress? What is the consequence of democracy preceding capitalism?

Let’s begin with the Mughals

India’s nationalist historians have portrayed its pre-colonial economy as a golden age of prosperity, and this fabulous wealth set the Europeans on their great voyages of discovery. During the Mughal Empire at the end of the 16th century, India’s wealth did indeed sustain more than 100 million people. With plenty of arable land, its agriculture was certainly as productive as Western Europe’s, and even the subsistence-oriented peasant got a decent return.9 India also had a large, skilled workforce that produced not only cotton but also luxuries for the aristocracy. Consequently, the economy produced a large financial surplus, which was used to support the growing Mughal Empire and finance spectacular monuments like the Taj Mahal.

In 1497, the Portuguese sent Vasco da Gama with a flotilla of four ships to find India’s wealth. But the two-year voyage was not a commercial success and the Indians were not interested in European clothes and goods for they made far ones in India. But Da Gama told King Manuel of Portugal of large cities, large buildings and rivers, and great populations. He spoke about spices and jewels, precious stones and “mines of gold.” He believed that he had found India’s legendary wealth.11

It took the English a hundred years to discover this wealth. Initially, they came to plunder but soon discovered the rewards of trade. They found that India produced the world’s best cotton yarn and textiles and in enormous quantities.12 What the Indians wanted in exchange from the Europeans was gold and silver, for which they had an insatiable appetite. Hence, there was a constant flow of gold to India, which absorbed a good deal of the bullion mined by the Spaniards in the New World. Having learned about cotton textiles from India, the English turned the tables, and brought an industrial revolution to Britain, but destroyed the lives of millions of Indian weavers.

India was a leading manufacturer in the 18th century

India was a leading manufacturing country in the world in the early 18th century. It had 22.6 percent share of the world’s GDP, which came down to around 16 percent by 1820, closer to its share of world population.13 It had a developed banking system and vigorous merchant capital, with a network of agents, brokers and middlemen. Given the enormous financial surplus, a skilled artisan class, large exports, plenty of arable land and reasonable productivity, the question is why didn’t a modern industrial economy emerge in India? Instead, why did India become impoverished?

Despite a dynamic and a growing commercial sector which responded to market forces and extensive foreign trade, the truth is that 18th century India was significantly behind Western Europe in technology, institutions and ideas. Neither an agricultural revolution, nor a scientific revolution had occurred, and in the long run the manual skill of the Indian artisan could be no substitute for technological progress,”14 and this would have needed new attitudes. Notwithstanding the surplus and the trade, mid-eighteenth India had a “per capita product perhaps two-thirds of that in England and France.”15

There is no easy answer to the problem that the country was prosperous and the people were poor. One explanation is that even in the 18th century India had a large population and plenty of cheap labor. Prosperity comes with rising productivity and a rise in productivity depends on technology. When the supply of labor is elastic, it is more economical to hire people than to invest in machines. Hence, an Englishman observed in 1807, “In India it is seldom that an attempt is made to accomplish anything by machinery that can be performed by human labour.”16 There is no easy answer to the problem that the country was prosperous and the people were poor. One explanation is that even in the 18 century India had a large population and plenty of cheap labor. Prosperity comes with rising productivity and a rise in productivity depends on technology. When the supply of labor is elastic, it is more economical to hire people than to invest in machines. Hence, an Englishman observed in 1807, “In India it is seldom that an attempt is made to accomplish anything by machinery that can be performed by human labour.”

Did the British Raj impoverish India?

India’s nationalist historians have blamed the British Raj for India’s poverty. The classic nationalist case is that India had been rich before the British came and colonialism weakened agriculture and “deindustrialized” India, throwing millions of artisans out of work. Britain’s trade policies encouraged the import of manufactures and the export of raw materials; finally, it drained the wealth of India by transferring its capital to Britain.

Nationalists claimed that Lancashire’s new textile mills crushed India’s handloom textile industry and threw millions of weavers out of work. India’s textile exports plunged from a leadership position before the start of the Britain’s Industrial Revolution to a fraction. The indigenous banking system, which financed these exports, was also destroyed. Since the colonial government did not erect tariff barriers, Indian consumers shifted to cheaper English mill-made cloth and millions of handloom workers where left in misery. British colonial rule “de-industrialised” India (a favorite nationalist phrase) and from an exporter of textiles, India became an exporter of raw cotton.17

Britain also changed the old land revenue system to the disadvantage of the farmer, who had to now pay revenue whether or not the monsoon failed. This led to famines. The worst one in 1896-97 affected 96 million lives and killed an estimated 5 million people. Although the railways helped in the trade of food crops, the enlarged national market sucked away the peasant’s surplus, which he had earlier stored for the bad years. Moreover, the British government transferred its surplus revenues back to England. Since India consistently exported more then she imported in the second half of the 19th century and early 20th century, Britain used India’s trade surplus to finance her own trade deficit with the rest of the world, to pay for her exports to India, and for capital repayments in London. This represented a massive drain of India’s wealth.18

In recent years some historians have challenged this nationalist picture. They have argued that Indian industry’s decline in the 19th century was caused by technology. The machines of Britain’s industrial revolution wiped out Indian textiles, in the same way that traditional handmade textiles disappeared in Europe and the rest of the world. Fifty years later Indian textile mills would have destroyed them. India’s weavers were, thus, the victims of technological obsolescence.19

They also found that the land tax had not been exorbitant—by 1900 it was only 5 percent of the agricultural output or half the average per capita tax burden. There had been a “drain of wealth”, but it was only about 1.5 percent of GNP every year. The revisionist historians argued that India’s payments to Britain were for real military and civilian services and to service capital investments. Also, the overhead cost of the British establishment—the so called “home charges”—was in fact quite small.20 If India had its own army and navy it would have spent more. True, India did have a balance of payments surplus, which Britain used to finance part of her deficit, but India was compensated by the import of gold and silver that went into private Indian hands.

India begins to re-industries

Indian entrepreneurs began to set up their own modern textile mills after 1850 and very slowly began to recapture the domestic market. In 1896, Indian mills supplied 8% of the total cloth consumed in India; in 1913, 20%; in 1936, 62%; and by 1945, 76%.21 Although India did not participate in global trade expansion between 1870 and 1913, Indian businessmen made large profits during the First World War, which they reinvested in after the war. Thus, India’s manufacturing output grew 5.6 percent per year between 1913-38, well above the world average of 3.3 percent.” 22 The British government finally provided tariff protection from the 1920s, which helped industrialists to expand and diversify.

By Independence in 1947, Indian entrepreneurs were strong and in a position to buy out the businesses of the departing British. Industry’s share in India’s GNP had doubled from 3.8 percent (in 1913) to 7.5 percent (in 1947), and the share of manufactures in her exports rose from 22.4 percent (in 1913) to 30 percent (in 1947).

Why didn’t an industrial revolution occur?

One of the intriguing questions of history is why India failed to create an industrial revolution. Karl Marx predicted that the railways would transform India and usher in an industrial revolution. Indeed, by the First World War, some thought that it was ready to take-off. By 1914, India had the third largest railway network, the world’s largest jute manufacturing industry, the fourth largest cotton textile industry, the largest canal system, and 2.5 percent of world trade.23 Although a colony, it had a very liberal regulatory regime–far more investor friendly than the one that replaced it after Independence—and after the 1920s the infant industry was also favored by tariffs. It had a merchant class hungry to become industrialists. Industrialization did, in fact, pick up after the War and industry’s share in national output doubled. But it was not enough to broadly transform an agricultural society. Modern industry employed only 2.5 million people out of population of 350 million.

Amiya Kumar Bagchi, the Marxist economist, suggests that the reason was the lack of effective demand during the colonial period, and this limited business opportunity. Indians were just too poor to buy modern goods and services.24 If the domestic Indian market was small, couldn’t the entrepreneur have supplemented it by producing for export? Morris D. Morris, blames supply constraints.25 An Indian entrepreneur was uncompetitive because of a shortage of technology, skilled labor, and capital—all of which raised his cost of his production. The historian, Rajat Ray, argues that Indian businessmen did not export because they made inferior products, unacceptable to the world market. In his view, technological backwardness was the single biggest failing.26 But surely, they could have imported technology, as Jamshedji Tata, G.D. Birla, and others did.

Unlike nationalist historians, I do not think there was a British conspiracy to deliberately under-invest in India or sabotage Indian business interests. Bombay’s textile mills were built with the credit, technical assistance and machines from Britain although they were a competitive threat to the Manchester’s mills. I believe the industrial revolution did not occur because Indian agriculture remained stagnant, and you cannot have an industrial revolution without an agricultural surplus or the means to feed a rapidly growing urban population; second, the international trading environment turned hostile with protectionism after the First World War, followed by the Depression; third, the colonial government did not educate the masses, unlike the Japanese state; finally, a colonial mindset pervaded the Indian middle class–even the hardiest potential entrepreneur lacks confidence when he is politically enslaved.

What is the verdict on British rule?

Did the British impoverish India? There is no question that in the 18th century it plundered and looted India’s wealth, as all conquerors have done in history. But did it create on-going institutions that were to India’s detriment? This has to do with the nature and theory of colonialism. True, its Industrial Revolution threw millions of weavers out of work, but it would have happened any way when the new technology reached India. British government policy could have cushioned the impact by erecting trade barriers and saved enormous amount of human suffering, but protecting handlooms would have been a temporary palliative.

Odd as it may seem, I believe that Britain did not “exploit” India enough. Had it made the massive investments in India that it did in the Americas, India would have become more prosperous and a much bigger market for British goods. A richer India would have been a better customer, a better supplier, and a firmer basis of Empire.27 Britain’s main failure was not to educate the Indian masses—hence 83 percent of Indians were illiterate at Independence. Britain’s education system in India produced only a thin upper crust of extremely well educated Indians, while the masses remained illiterate.28

Although Britain could not lift Indians out of poverty, nor avert famines, it did give India the institutions of democracy–the rule of law, an independent judiciary and a free press. It built railways, canals, and harbors. It gave India almost a hundred years of peace—the Pax Britannica. Although it gave modern values and institutions, it did not interfere with its ancient traditions and religion. Hence, India has preserved its spiritual heritage and the old way of life continues. Many despair over the divisiveness of caste, but the hold of the Indian way of life is also a bulwark against the onslaught of the global culture.

Independence and ‘License Raj’

After Independence, democracy took root in India and gradually the masses acquired a stake in the system, periodically electing representatives even from the lowest castes. The rulers also adopted a Fabian socialist economic path, and Indians did not turn to capitalism until 1991, although there was modest liberalization of the economy in the 1980s. Thus, India embraced democracy before capitalism, which makes its journey to modernity unique and explains a good deal.

Jawaharlal Nehru and his planners did not trust private entrepreneurs; so they made the state the entrepreneur, and not surprisingly, they failed to create an industrial revolution. Instead, India experienced an agricultural revolution in the early 1970s. It thus had an important pre-condition for the industrial revolution—an agricultural surplus—but the industrial take-off eluded it. Its investment rate also rose from 6 percent to well over 20 per cent, and yet it did not engender a take-off. Why?

I think there were at least six things wrong with India’s mantra: one, it adopted an inward-looking, import-substituting path rather than an outward-looking, export-promoting route; it thus denied itself a share in world trade and the prosperity that trade brought in the post-War era. Two, it set up a massive, inefficient, and monopolistic public sector to which it denied autonomy of working; hence, its investments were not productive and it had a poor capital-output ratio. Three, it over-regulated private enterprise with the worst controls in the world, and this diminished competition in the market; four, it discouraged foreign capital and denied itself the benefits of technology and world class competition. Five, it pampered organized labor to the point that it has extremely low productivity. Six, it ignored the education of its children.

Nehru’s strategic planner, P.C. Mahalanobis, made two wrong assumptions. He assumed that there were no opportunities for rapid export expansion in the 1950s, and this turned out to be wrong. India discovered that tiny Hong Kong could earn more from its exports than the whole of India, as India’s share of world trade declined from 2.2 percent in 1947 to 0.5 percent in 1990. He also assumed that competition was wasteful, and this was also a flawed idea because there can be little improvement in productivity without it.

Even more damaging were the creeping controls on the private sector. The most bizarre was the licensing system. It began with the Industrial Licensing Act of 1951, which required an entrepreneur to get a license to set up a new unit, to expand it, or change the product mix. A huge number of untrained clerks, engineers, bureaucrats at the Directorate General of Technical Development, operating on the basis of inadequate information vetted thousands of applications on an ad hoc basis. These low level functionaries took months in the futile, micro-review of an application and finally sent it for approval to the administrative ministry. The ministry again lost months reviewing the same data before it sent the application to an inter-ministerial licensing committee. After the Minister’s approval, the investor had to seek approval for the import of machinery from the capital goods licensing committee. If finance was needed from a State financial institution, the same scrutiny had to be repeated afresh. The result was enormous delays, sometimes lasting years with staggering opportunities for corruption.

Large business houses set up parallel bureaucracies in Delhi, to follow up on their files, organize bribes, and win licenses. If the entrepreneur did finally get started and made a success of his enterprise, he was again in trouble. It was an offence punishable under the law to manufacture beyond the capacity granted by the license. India became the only country in the world where the production of sorely needed goods sorely was punishable by law.29

The system ended in thwarting competition, entrepreneurship and growth, without achieving any of its social objectives. It fostered monopolies and it proliferated uneconomic-size plants in remote, uncompetitive locations, employing second-rate technology. Bureaucrats who did not have a clue about the basics of running a business made the decisions on the choice of technology, the size and location of plants.

Although it was becoming clear that India was on the wrong path by the late sixties, instead of changing course after Nehru, Indira Gandhi introduced more controls. She nationalized banks, discouraged foreign investment, and placed more hurdles before domestic enterprise. Hence, industrial growth plunged from 7.7 per cent a year between 1951-1965 to 4.0 per cent between 1966-1980. Productivity of Indian manufacturing declined half a percent a year from 1960 to 1985.30

“1966-1980 is effectively the dark period for the Indian economy.”31. It is harder to blame Nehru for adopting the economic wrong model for socialism was the wisdom of his age and dozens of economists visited India and hailed his bold experiment.32 It is right to blame Indira Gandhi, for by then Japan’s miracle was evident, and Korea and Taiwan were following its footsteps. However, ideology is only one part of the story. An important reason for non-performance was poor implementation. Even Nehru’s socialism could have delivered more and did not have to degenerate into “License Raj”.

India after the Reforms

Although there was modest liberalization in the 1980s, the decisive turning point came in July 1991 when the minority government of Narasimha Rao announced sweeping reforms. It opened the economy to foreign investment and trade; it dismantled import controls, lowered customs duties, devalued the currency and made the rupee convertible on the trade account; it virtually abolished licensing controls on private investment, dropped tax rates and broke public sector monopolies. As a result growth rose to 7.5 percent a year for three years in a row in the mid-nineties, inflation came down from 13 percent to 6 percent by 1993, exchange reserves shot up from $1 billion to $20 billion by 1993, and had crossed $100 billion by end 2003. This was as important a turning point as Deng’s revolution in China in December 1978. Surprisingly, the elected coalition governments that succeeded Rao continued the reform process, and despite its slow, incremental pace, it has made India one of the fastest growing major economies in the world.33

Indians have traditionally not accorded a high place to making money. Hence, the merchant or bania is placed third in the four-caste hierarchy, behind the brahmin and the kshatriya, and only a step ahead of the laboring shudra. After the economic reforms making money became increasingly respectable and the sons of brahmins and kshatriyas began to get MBAs and wanted to become entrepreneurs. The business pages of newspapers became livelier; chief ministers in the states scrambled for private investment; judges became more even-handed in industrial disputes. As a result, India is in the midst of a social revolution rivalled, perhaps, only by the ascent of Japan’s merchant class during the 1968 Meiji Restoration.

There has also been mental revolution. And a changed attitude to English illustrates this new mindset. Ever since the British left Indians constantly carped against the English language. But in the 1990s this carping seemed to die, and quietly, without ceremony English became one of the Indian languages. English lost its colonial stigma, oddly enough, around the time that the Hindu nationalists came to power. Young Indians in the new middle class think of English as a skill, like Windows. This is why Hinglish (Hindi mixed with English) is spreading. Encouraged by flourishing private television channels and supported by their advertisers, the newly emerging middle classes avidly embrace this uninhibited hybrid of Hindi and English, and this popular idiom of the bazaar is rushing down the socio-economic ladder. The purists naturally disapprove, but people are more comfortable and accepting of it today because Indians are more relaxed and confident as a people. Their minds have become decolonized.

The world, meanwhile, also changed from an industrial to the information economy, and it seemed to speak to India’s advantage, symbolized by its success in software and business process outsourcing. These “Bangalores” have given Indians confidence and they reflect a new social contract. The new entrepreneurs did not inherit wealth; they have risen on the back of their talent, hard work, and professional skills. A new self-belief has emerged among urban youth that doesn’t need approval from others, especially from the West. Music composers like A.R. Rehman display an exuberant nonchalance, as do the new young Bollywood pop stars. So do new fiction writers like Arundhati Roy, designers of fashion clothes, beauty queens and cricket stars.

Some lessons

Neoclassical economic theory explains a great deal about why the Indian economy that was stagnating in the first half of the 20th century went on to become one of the fastest growing by the end of the century. It tells us, for example, that disgraceful protectionism by governments in the inter-war years in the first half of the 20th century dampened world trade and slowed down the world and the Indian economies. It also explains why India performed below the world average between 1950-1980: thinking that trade had impoverished her in the colonial period, India closed its economy and denied itself the fruits of a “golden period” in world trade between 1950 and 1970; “License Raj” and other institutions of Nehru’s socialism also suppressed growth. Finally, neoclassical economics explains how by dismantling controls and integrating the economy with the global economy, the Indian economy has become more competitive and is growing rapidly after the reforms.

But this is not the whole story, and we must turn to institutions and attitudes to understand the incentive structure of the Indian society.60 Indians blame colonialism for impoverishing them. But we have seen that colonialism is a more complex tale. For example, it did not ‘de-industrialize’ India as the nationalists argued; handloom textiles died in India (and the world) because of technological obsolescence. Colonialism’s bigger damage was to the loss of Indian confidence, which inhibited Indian entrepreneurs. This confidence began to grow with Gandhi’s freedom movement in the first half of the 20th century, and industrialization did pick up. However, its impact on society was insufficient to create an industrial revolution.

After Independence, India’s confidence certainly rose as democracy took root, but flawed economic institutions of Nehruvian socialism acted as a damper. Once these socialist institutions began to be replaced by capitalist ones in the Reform period, self-assurance returned to the Indian marketplace. Today’s mood in India is opposite to what existed a hundred years ago. Insecurity and inferiority filled colonial India, which is all too apparent in the writings of Bengali writers of the 19th century, such as Bankim Chandra Chatterji. Today, writers like Salman Rushdie and Arundhati Roy exhibit a matter of fact assuredness (almost a cool) that is a reflection of changed national mindset.

India embraced democracy first and capitalism afterwards and this has made a difference. India became a full-fledged democracy in 1950, with universal suffrage and extensive human rights, but it was not until 1991 that it opened up to the free play of market forces. For the rest of the world it has been the other way around. In the West, suffrage was extended gradually in the last century, and as mass political parties developed, democracy began to impinge on capitalist institutions and practices.

India’s democracy has an overwhelming majority of poor voters–70 per cent still live in rural areas; organized labor constitutes less than 10 per cent of total labor; and the middle class is around 20 per cent of the population. Because of democratic pressures, India tried to redistribute the pie before it was baked. It set up intricate regulatory networks before the private economy had transformed a rural into an industrial society. It began to think in terms of “welfare” before there were welfare-generating jobs. The result, as we have seen, was a throttling of enterprise, slow growth, and missed opportunities. It is the price India has paid for having democracy before capitalism—or rather too much democracy and not enough capitalism.

Since politics is a short run game and growth is a long run one there will never be a situation that is completely optimal. This explains why Indian politicians do not bother about education because results take a long time to come. When a politician promises rice for two rupees a kilo when it costs five rupees in the market, he wins the election. Since the mid-1960s politicians have vigorously competed in giving away free goods and services to voters. When politicians do that, where is the money to come for creating schools or improving old ones? India’s damaging fiscal deficit (around 10 percent of GDP for the center and states combined) is a testimonial to the downside of competitive politics, and it teaches that the demand for publicly provided goods and services is insatiable in a democracy.

But India’s problems of governance go far beyond the need to appease interests. The weakening of its democratic institutions since Indira Gandhi in the 1970s has caused widespread corruption, political violence, populist giveaways, and a paralysis of problem solving. Conspicuously absent are disciplined party organizations, which help leaders in other democracies to mobilize support for specific programs. Hence, there is an excessive reliance on the personal appeal of individual leaders to win elections. When in power leaders tend to take the easy way out, which is not to act at all.

Will capitalism, and its cousin globalization succeed in establishing a comfortable place for themselves in India? The answer depends on their ability to deliver prosperity broadly. It also depends on leaders in the government and in business to champion the classic liberal premises of free trade and competition. It needs leaders to come out say that (1) some people will not fare as well in the competitive market place; (2) the winners will far outnumber the losers; (2) capitalist democracy is the best arrangement we have found; (4) globalization is not only a good thing, it is a great leap forward in history. My fear is that capitalism’s success in India is threatened not so much by the leftists or protectionists but by the timidity of its defenders.

The curious historic inversion between democracy and capitalism means that India’s path into the future is evolving through a daily dialogue between the conservative forces of caste, religion and the village, the leftist and Nehruvian socialist forces which dominated the intellectual life of the country for 40 years, and the new forces of global capitalism. These “million negotiations of democracy” slow down the pace of economic reforms, but they also mean that India might have a more stable, peaceful, and negotiated transition into the future than say China. It might also avoid some of the deleterious side effects of an unprepared capitalist society, such as Russia. Although slower, India is more likely to preserve its way of life and it’s civilization of diversity, tolerance, and spirituality against the onslaught of the global culture.

Does culture matter?

Cultural explanations have been a vigorous industry in India for more than a hundred years. Colonial officials routinely blamed India’s poverty on the otherworldly spirituality of Hindu life and its fatalistic beliefs. Max Weber attributed the absence of development to the caste system. Gunnar Myrdal, the Swedish economist, found that India’s social system and attitudes were an important cause of its “low level equilibrium” of low productivity, primitive production techniques, and low levels of living.34

Deepak Lal, another economist, similarly explained economic stagnation in a low level “Hindu equilibrium” around the caste system, which bought stability in the context of political warfare, monsoon failure and climatic uncertainty, labor shortage, and an under-valued merchant class.35 David Landes, the historian, blames the enervating heat, which is deleterious to work. For this reason, rich countries lie in temperate zones and the poor in the tropics and semi-tropics.36

While institutions and culture do matter undoubtedly, we are all skeptical of national stereotypes and easy cultural explanations of the sort that were common hundred years ago. In my experience, successful Hindu entrepreneurs can be both extremely otherworldly in religion and aggressive in business. The Indian farmer, despite being caught in the caste system, responds quickly to market based incentives, as the Green Revolution testifies. Brahmins, who are supposed to have contempt for manual labor, will plough their land vigorously if they have to. And Rajput Thakurs, who never worked for a living, will shed their feudal ways for the sake of a commercial opportunity. Moreover, there are substantial non-Hindus in India and these communities had also been stuck in the same rut of stagnation. Other Asian countries were equally backward, but they had no “Hindu equilibrium” to explain away their stagnation. Finally, the same Indians when they migrate to other countries perform better.

Thus, I am uncomfortable with the “otherworldly values of the Hindus” or the “immobilizing effects of the caste system” and the “conservative habits of the merchant caste”. I believe that Sir John Hicks’ Economic Principle does trump in most cases. It states that “people would act economically; when the opportunity of an advantage was presented to them they would take it.”37 It explains not only the diffusion of the Green Revolution across India but also the demographic transitions currently underway in many states.

When seeking an explanation for a nation’s wealth and poverty, my preferred method is to begin with economic factors as proximate causes that motivate a businessman to invest–the size of the market, the capability of suppliers, distribution hurdles, and the state of competition. If this does not satisfy, I seek answers in institutions, some of which are, of course, intimately tied to culture. I have found that institutions can evolve rapidly as incentives change in society and can be transferred fairly quickly; for example, during the 1990s India was able to dismantle many of the institutions of Nehruvian socialism and replace them with capitalist institutions. Finally, if none of these factors provide a satisfactory explanation, then I turn to attitudes and social structure.

I find Deepak Lall’s distinction between material and cosmological beliefs useful.38 The material beliefs of a civilization are about ways of making a living and are the subject of economics; cosmological ones are about how to live and are in the realm of ‘culture’. The rise of the west was accompanied by a change in both sets of beliefs, but East Asia’s success has needed mainly a change in material beliefs—it has become prosperous without losing its soul. In other words, it is possible to modernize without westernizing. Ever since the British Raj material beliefs have been changing in India unlike our cosmological beliefs.

Our continuing inability to distinguish between the “modern” and the “western” in India is surely the cause of some of our grief. If we could only accept that a great deal of modern western culture, especially its material beliefs, are not the West’s property, but are a universal, critical way of thinking, which belongs to all rational human beings. We would not waste our energies on swadeshi (protectionism) hindutva (preserving the ancient Hindu civilization), and futile language debates (“remove English from primary schools”). The debate between modernisation and westernisation, begun in early nineteenth century by Ram Mohan Roy, continues to rage in India. At the root is a fear of the loss of the Indian way of life. The older generation fears it more than the young, whose minds are more decolonised and who are more confident in adopting the West’s material beliefs without fearing the loss in its cosmological ones.